Speech
Some Observations on the Cost of Housing in Australia

In recent years, there has been concern in many sections of the community about the
cost of housing in Australia. This is not the first time that such concerns
have surfaced: the 2003-04 Productivity Commission Inquiry on First Home Ownership
was preceded by studies into housing issues in 1977–78 and
1990–92.[2]
But the current episode of high housing costs has been quite prolonged, and
there are few indications that any amelioration is in prospect in the near
term.

In this talk, I will provide an update on some trends in housing prices and affordability,
and discuss some of the factors that have influenced these outcomes.

I will begin with a graph of housing prices and some housing-related ‘fundamental’
factors (Graph 1). One clear fact is that in the 35 years since 1972,
nationwide house prices have risen significantly faster than average household
incomes, house-building construction costs, and average rents. Most of the
increase in real house prices occurred in two episodes, in the late 1980s boom
and the subsequent boom in the late 1990s and into this decade. Growth in prices
has been broad-based across the different states and territories. The run-up
in prices is likely to mostly reflect an increase in the price of
land.[3]

Graph 1

The increase in housing prices has been a mixed blessing for Australians. At one
level, rising housing prices have made many people feel wealthier and have
contributed to higher levels of consumer spending than might otherwise have
occurred. But they have also resulted in concerns about housing affordability.

The difference in views reflects the fact that housing is not just an asset but also
a consumption item. When housing is thought of purely as a consumption item,
it would seem that in aggregate we would be better off if its price were lower.
Because we all need to consume some level of housing services, either rented
or purchased, a higher level of housing prices and rents allows less spending
on other items.

But housing is also a long-lived asset, and there are distributional aspects to changes
in housing prices and rents. Renters will be worse off when housing prices
rise whereas those who own rental property will be better off. Owner-occupiers
may be largely unaffected, since they can be thought of as being ‘hedged’
against increases in the cost of housing. There are also generational differences.
Younger people who have not yet bought homes will be hurt by higher housing
prices. Older owner-occupiers may benefit from an increase in prices if they
are intending to extract part of the increased value of their homes. Of course,
if older people pass on some of their increased wealth to younger relatives,
the gains and losses of these two age groups will be reduced. Indeed, the biggest
difference may be between those who benefit from transfers from older relatives
and those who do not. Both home ownership and ownership of rental property
tend to rise with incomes (Graph 2), so it is lower income households
that tend to suffer from rising housing prices and higher income households
that tend to gain.

Graph 2

But although there are significant distributional effects across the age and income
structure, one can make the case that the population in aggregate does not
benefit from increases in housing
prices.[4][5]

This discussion of housing as a consumption item leads us to the issue of housing
affordability.[6]

For renters, affordability is typically measured by the ratio of rent paid to household
income (Graph 3). Survey data show that the proportion of income being
allocated to rent payments has risen over the past two decades for renter households
of all income
levels.[7]
In addition, the share of lower income households in ‘housing stress’
has tended to
rise.[8]

Graph 3

In the case of home buyers, concerns about affordability are typically about the
accessibility of home ownership, or the ability of younger households
to gain access to home ownership for the first time. The standard measures
of accessibility show an improvement when average household income is growing
faster than housing prices, or when mortgage interest rates are falling so
that the borrowing power of households is increasing. Such measures suggest
that there are cycles in affordability, but that it was at low levels by historical
standards at the end of 2007
(Graph 4).[9]

Graph 4

But the existing measures of housing accessibility have a few shortcomings. Most
importantly, they tend to focus on the average income level for
all households rather than focusing on households in the age groups
that are typically looking to purchase homes.

Accordingly, we have calculated an alternative measure which represents an estimate
of the proportion of all dwellings (both houses and apartments) transacted
in any year that would have been accessible to a typical household in the prime
home-buying years, based on certain assumptions about bank lending
behaviour.[10]
We focus on households headed by persons aged between 25–39 years as
potential home buyers. The estimates suggest that in four of the major capitals,
around 30–35 per cent of transacted dwellings (houses and apartments)
would have been accessible to the median household in the home-buying age groups
in 2006/07 (Graph 5). Perth was the exception, where only around 10 per
cent of dwellings would have been accessible. Taking account of accessibility
outside the capital cities, we estimate that on a nationwide average basis
around 33 per cent of transacted dwellings would have been accessible
to the median young household in 2006/07, compared with a longer-run average
of around 45 per cent. Of course accessibility would have been much lower for
many lower-income
households.[11]

Graph 5

An alternative way of looking at affordability for younger households is to consider
trends in the real income that this group would have had after servicing a
mortgage of a given size
(Graph 6).[12]
The data indicate that real residual income of this group would have fallen
between the early 1980s and early 1990s, but then would have increased through
to 2006/07. For the 25-year period from 1982/83, expenditure on servicing a
mortgage would have grown faster than income. But the real residual income
available for other goods and services would nevertheless have grown, by around
0.5 per cent per annum. So the increase in housing prices has not in aggregate
terms resulted in a fall in real spending on other goods.

Graph 6

I will turn now to the determinants of housing affordability and housing prices.

In any discussion of whether there is an affordability problem, we should remember
that the run-up in housing prices in Australia has not occurred in isolation,
with many other countries also experiencing housing booms. Admittedly there
are problems of comparability when looking across countries, but the data suggest
that Australia's median house price to income ratio is quite high by
international standards (Graph 7).

Graph 7

An additional perspective on this issue comes from the fact that the standard accessibility
measures are driven by three variables: housing prices, household incomes and
mortgage interest rates. So we can consider whether the relatively low levels
of affordability in Australia over the past five or six years are more a function
of housing prices being high relative to incomes, or to mortgage interest rates
being relatively high. The data show that the recent period when affordability
measures have been at low levels has been a period when the housing price to
income ratio has been well above its average level for the low inflation period
(Graph 8). Mortgage rates will of course fluctuate, but they could not
be said to have contributed significantly to the persistently low levels of
housing affordability over the past five or six years.

Graph 8

So looking either at the standard inputs into accessibility ratios or at an international
comparison, it appears that the low level of housing accessibility in Australia
can be thought of mostly as a reflection of the persistently high level of
average housing prices. Given that houses and apartments can be either rented
or owner-occupied, this high level of housing prices affects both home buyers
and renters.

Of course, we must recognise that housing prices are not set exogenously, but reflect
the interaction of demand and supply.

Certainly there are many well understood factors (the long economic expansion, the
fall in inflation and interest rates, developments in the financial sector,
etc) that have contributed to the household sector choosing to spend more money
on housing.[13]
Indeed, the experience of the past couple of decades suggests that, for a significant
part of the population, housing may have been something of a ‘superior
good’, that is the type of good to which consumers devote an increasing
share of their income as incomes rise. To some extent, the recent experience
might also suggest that in the earlier era of high interest rates and a regulated
financial system, households were unable to spend as much on housing as they
might otherwise have chosen.

In addition, a number of demographic and social trends have increased the demand
for housing in the economy. And the effect of these ‘fundamental’
factors have probably been added to by increased demand for housing as an asset,
due to aspects of the tax system and a broader shift in attitudes about housing.

It should not be surprising that these demand-side factors have boosted housing prices,
especially the price of more favourably located housing which is in limited
supply.[14]
Indeed, within our largest cities, house prices have increased more in closer-in
suburbs than in more distant ones in recent decades
(Graph 9).[15] In four
of the five major capitals, average annual growth in house prices within five
kilometres of city centres has been about 2 percentage points higher
than for houses close to the edge of the cities: the exception is Adelaide
where the difference is smaller. In addition, waterfront suburbs have had
annual price growth around ½–1 percentage point higher than
similarly proximate non-waterfront
suburbs.[16]
The greater run-up in closer-in and waterfront suburbs suggests that as the
income and borrowing power of households has risen, there has been greater
competition for housing that is viewed as more desirable.

Graph 9

So demand factors have played an important role in the run-up in housing prices.
However, developments on the supply side should have worked to dampen the impact
of demand pressures somewhat. As the value of land rises there is an incentive
to increase the intensity of its use, for example by building townhouses on
land that was previously used for single family houses or building high-rise
apartments on land previously used for small blocks of units.

The demand factors discussed above would be expected to have contributed to some
increase in real housing prices even far from the city centres. However, supply-side
factors should have a much greater influence on prices towards the fringes
of cities, where land is less scarce and accounts for a smaller proportion
of the total dwelling price. In principle, the price of housing there should
be close to its marginal cost, determined as the sum of the cost of new housing
construction, land development costs, and the cost of raw land. And in the
absence of any restrictions on supply, the price of raw land on the fringes
should be tied reasonably closely to its value in alternative uses, such as
agriculture. So unless there has been a marked increase in the value of this
land when used for other purposes, the availability of additional land towards
the edges of our cities should have limited increases in the cost of housing
there.

However, the evidence in Graph 9 provides only limited support for the
proposition that real housing prices should not have risen significantly in
suburbs far from the CBD. While price growth has been strongest in the most
desirable suburbs, the fact is that real price increases in the outer suburbs
have been quite large as well. Hence, in 2006/07 median prices of houses in
suburbs in the outer parts of the capitals were typically in the $250,000–$300,000
range, except in Perth where prices were slightly higher (Graph 10).

Graph 10

So if we are looking for explanations why housing is not as affordable as we might
like, it may be necessary to look at factors on the supply side as well. One
obvious place to start is the cost of land for building new houses near the
edges of our cities. To shed some light on this, in late 2007 Reserve Bank
staff looked at newspaper advertisements and websites for new housing developments
in each of the five major capitals, focusing on the least expensive land available
in major developments. These were typically lots around 400 square metres in
size, ranging from around 25 kilometres (Adelaide) to around 40 kilometres
(Sydney, Perth and Melbourne) from the CBD. Entry-level lots ranged from around
or a little below $100,000 in Melbourne and Adelaide to around $200,000 in
Sydney and Perth (Graph 11). The implied per hectare price of the developed
land ranged from a little over $2 million in Melbourne to around $5 million
in Sydney and Perth. These were representative prices for low-cost land, with
the average cost of building sites noticeably higher.

Graph 11

In considering the reasonableness of these prices, it must be remembered that our
major cities are all coastal, and in some cases there are mountain ranges or
other geographic or environmental factors which are a consideration –
but not generally an absolute barrier – for development. However, this
exercise raises the question of whether the cost of land on the fringes of
our cities could be a disincentive to building new housing there, and in the
medium term could also be increasing the price structure of the existing housing
stock.[17]

There are no doubt a number of factors that could be contributing to the observed
level of land prices, and the relative importance of these is probably best
left to experts. One factor that has been widely mentioned is the existence
of various constraints on land development, including growth corridors and
boundaries. Another factor that has been mentioned is the existence of a range
of government charges, including developer levies or infrastructure charges.
More broadly, concerns have also been expressed that zoning policies and building
approval processes have hampered in-fill development closer to the city centres.

Both economic theory and international evidence suggest that housing prices can be
boosted by land usage policies (which can create artificial scarcity of residential-zoned
land), problems with the complexity of the development process (which creates
rents), and the fees and charges imposed on
development.[18]
Accordingly, the fact that higher prices for housing have not resulted in a
more significant supply response could be a reflection of various supply-side
costs that have represented a wedge in the cost of bringing new housing to
market.[19]

This suggests that the run-up in real housing prices may not be fully explained by
demand-side factors and that supply-side ones – especially policies on
land usage – may also have played a role. Of course, this is not to argue
that all policy intervention in the land market is inappropriate, but rather
that the benefits from zoning regulations, growth boundaries, infrastructure
charges, etc should be weighed against any costs in terms of higher housing
prices. To quote Bertaud and Malpezzi (2001, p 393), ‘Land use regulation
per se is neither good nor bad. What matters is the cost and benefit
of specific regulations under particular market conditions’.

Let me conclude with a few final observations.

It is no doubt the case that housing will never be as ‘affordable’ as
we might like, and indeed the cost of housing has been the subject of periodic
concern for at least several decades. And, to a large extent, the outcomes
that have been seen over recent decades appear to reflect market outcomes,
especially the impact of a series of factors which have boosted demand for
housing. As the 2004 Productivity Commission report noted (p 7), ‘…the
apparent decline in affordability over the long term may partly result from
the collective decisions of households to spend a greater share of their incomes
on housing’.

However, various commentators and industry groups have argued that there are also
some factors on the supply side that have boosted the price of new housing
and limited the expansion of housing supply that could have moderated the worsening
in affordability. Overall, it seems likely that developments in housing prices
close to CBDs mostly reflect demand-side factors, but that supply-side factors
might have materially affected housing prices near the fringes of our major
cities.

As the Productivity Commission report noted (pp xxii–xxiii) ‘there is
limited scope for governments to improve affordability for first (and other)
home buyers in the short term … However, governments do have an important
role to play in facilitating efficient housing outcomes. In particular, policy
initiatives to address any structural factors that encourage excessive demand
for housing, or that unnecessarily reduce the responsiveness of supply to increases
in demand, will reduce ‘average’ house prices over future cycles
and could provide enduring affordability benefits to both home buyers and renters’.
The discussion in this paper suggests that those observations in the Productivity
Commission report remain valid. On the demand side, it is now widely accepted
that policies that simply give people more money to spend on housing are likely
to be capitalised into higher housing prices. On the supply side, efforts to
improve housing affordability should be focused on policies regarding land
use and on improving efficiency in the supply of land and housing.

Endnotes

I thank a number of colleagues, especially Gianni La Cava, Laura Berger-Thomson and
Michelle Wright, for their contributions to the material in this talk.
[1]

See Committee of Inquiry into Housing Costs (1978) and National Housing Strategy
(1992).
[2]

Part of this run-up in prices has reflected improvements in the quality of the housing
stock: Abelson and Chung (2005) suggest that quality improvements from
alterations and additions could have boosted house prices by around 1 per
cent per annum over 1970-2003. But, while the size and quality of houses
and apartments may have increased, the average amount of land per dwelling
is likely to have fallen: a number of sources suggest that average lot sizes
of new freestanding houses tend to be smaller than in the past and the increasing
shares of townhouses and high-rise apartments in the overall housing stock
also imply a smaller average amount of land per house or per apartment. So,
in aggregate terms, improvements in the size of dwellings and the quality
of their inclusions are likely to have been offset to some extent by ‘quality’
reductions in terms of the average amount of land per dwelling. So the sharp
run-up in housing prices over the past two decades is likely to be more a
reflection of an increase in the price of land rather than of changes in
the quality of the dwellings, when quality is defined broadly to include
both the structure and land content. This is consistent with the observation
that price growth appears to have been somewhat faster for houses (which
have a relatively higher land content) than apartments, and in capital cities
(where land is relatively more scarce) as opposed to outside the capitals.
[3]

Bajari, Benkard and Krainer (2005) illustrate this in a formal economic model, finding
that ‘there is no aggregate change in welfare due to price increases
in the existing housing stock. This follows from a simple market clearing
condition where capital gains experienced by sellers are exactly offset by
welfare losses to buyers … [W]hile price changes do not result in
aggregate changes [in welfare] … this is far from true at a disaggregated
level … Housing inflation involves a redistribution of income between
those buying and those selling their homes’(pp 474, 483).
[4]

This is not to say that housing does not represent wealth for home owners: it clearly
does, as home-owners have prepaid their future housing needs. And even if
it is unclear whether rising house prices per se can be viewed as adding to real net wealth, it is clear that
many of the factors – strong economic growth, lower unemployment, a
more dynamic financial system, etc – that have contributed to rising
house prices are extremely positive and have contributed to higher real income
levels.
[5]

Before looking at the data on affordability, it may be worth addressing the argument
that the aggregate home ownership rate has not changed significantly over
the past couple of decades, which is evidence that ‘affordability’
is not a problem. In fact, home ownership rates of most age groups have fallen
significantly in recent years. For example, home ownership among 25–39
year olds – typically the age when people first enter into home ownership
– has fallen from around 65 per cent in 1986 to 58 per cent in
2006. Abstracting from shifts in age structure of the population, the average
home ownership rate has fallen by around 4 percentage points since 1986.
Of course this may reflect broader social trends and changes in preferences.
However, the fact that home ownership rates have fallen within age groups
despite major improvements in the availability of finance suggests that the
run-up in the cost of housing since the mid 1980s might have had some impact
on home ownership.
[6]

These survey findings may appear at odds with the data in Graph 1 that suggest average
rents have not risen as much as average incomes or house prices over recent
decades. It is unclear what explains this divergence: it may reflect sampling
error in the survey data, or the relatively poor long-run data for average
rents in Graph 1, which are based on spliced REIA and ABS data.
[7]

One widely used definition of housing stress is when housing costs (either rent payments
or mortgage servicing) exceed 30 per cent of household income for those households
in the bottom 40 per cent of the income distribution. Note that the 30 per
cent threshold would be considered too low for higher-income households.
[8]

The median dwelling price affordability measure is the ratio of average household
disposable income to principal and interest repayments on a new 25-year mortgage
for the REIA median-priced dwelling assuming an 80 per cent loan to
valuation ratio (LVR) and the average interest rate paid on new loans. The
CBA/HIA index is the ratio of average household disposable income to the
disposable income required to purchase the estimated median-price CBA-financed
first-home-buyer dwelling assuming an 80 per cent LVR, a new 25-year
mortgage, the CBA mortgage rate and a 30 per cent repayment to gross
income ratio. The deposit gap is the difference (as a proportion of average
gross income) between the REIA median dwelling price and the amount that
someone earning average household gross income could borrow based on a 25-year
mortgage, the average interest rate paid by new borrowers and a 30 per cent
repayment to gross income ratio.
[9]

More precisely, based on ABS survey data, we calculate median gross household income
for 25–39 year olds in the state capital and ‘rest-of-state’
for NSW, Victoria, Queensland, South Australia and Western Australia. We
then calculate borrowing capacities based on these income levels and representative
mortgage interest rates. Subject to a 30 per cent repayment/gross income
ratio, we then calculate purchasing capacity assuming that the household
had also saved a deposit of 10 per cent of the purchase price.
[10]

In addition, unlike Graph 4, the data in Graphs 5 and 6 do not reflect the increases
in mortgage rates that have occurred in the second half of 2007 (and none
of the graphs reflects changes in the early part of 2008).
[11]

In particular, the graph shows the real residual income that a potential first-home
buying household would be left with after purchasing a home at the 30th percentile of the price distribution, after putting down
a 10 per cent deposit.
[12]

Further discussion of the factors behind the run-up in housing prices is provided
in the report by the Productivity Commission (2004) and the submission by
the Bank (RBA 2003). See Battellino (2007) for further discussion of the
rise in household indebtedness in recent years.
[13]

Standard theoretical models of urban structure assume that much of the economic activity
in a city is in the CBD. Since travel is costly in terms of time and money,
people will pay a premium to be close to the CBD. Anything that increases
the monetary or opportunity costs of travel should increase the premium for
closer-in suburbs. Given the increase in real incomes over time, the opportunity
cost of commuting will have increased, so the relative price of closer-in
suburbs should have risen. In addition, if growth of our cities has resulted
in an increase in congestion and commuting times (for example, if transport
has not improved in tandem with population growth) the premium for closer-in
suburbs should have increased.
[14]

Growth in median prices is calculated for all postcodes for which there are at least
15 transactions in the beginning and end-years. The lines represent fitted
values from a regression of the average annual growth in prices (or the log
of prices in Graph 10) on distance and distance-squared and a variable
denoting if the postcode is waterfront (either harbour, ocean or riverfront).
Some modest restrictions were placed on the shape of the polynomial, and
a few outliers were omitted from the regressions. Of course, many other factors
could be expected to explain the level or growth in house prices, but the
regressions shown have a surprisingly high explanatory power (the median
adjusted R-squared is 0.60 for the growth equation and 0.49 for the levels
equation).
[15]

Proximity to waterfront appears to be valued most highly in Sydney and Perth, where
it boosts median prices by 50–60 per cent. The effect in Brisbane and
Melbourne is smaller, and the effect in Adelaide is quite modest.
[16]

A similar exercise for some US cities would also suggest that Australian land prices
are quite high. For example, contacts in Dallas and Atlanta suggest that
prices for new developments on the fringes of those cities can start around
US$50,000 or less, for lot sizes that are typically several times the size
of Australian blocks. Admittedly neither of these cities is coastal, but
nor are they small: both are larger than Sydney and Melbourne, with Greater
Atlanta having a population of 5.3 million and Dallas-Fort Worth with around
6 million people.
[17]

See Brueckner (2007) for a theoretical overview of the impact of land usage policies
on housing prices. See Grimes (2007) for an overview of some empirical
research in New Zealand, and Green, Malpezzi and Mayo (2005), Quigley and
Raphael (2005), and Glaeser, Gyourko and Saks (2005a, 2005b, 2006) for
US evidence.
[18]

One argument that is sometimes heard is that developer behaviour may be contributing
to the current high cost of land. For example, in New South Wales it has
been argued that the expectation of continuing scarcity of new land and of
strong housing price growth led developers to pay high prices for land in
the early part of this decade. Given the price falls for existing housing
in the outer suburbs, they are now faced with reduced profits (or even losses)
on land holdings, so the argument goes that they are now ‘hoarding’
land until prices increase. However, in other more competitive industries,
firms have to accept the current market price for their output and any losses
from changes in input prices are bygones – holding out will simply
increase their losses because other firms will come in and supply the market
at the market-clearing price. So if it is the case that prices are being
held up by firms sitting on zoned land and waiting for prices to recover,
this points to deeper problems in the land supply process – that the
process is not sufficiently competitive for other firms to come in and sell
other land at the new (lower) market-clearing price.
[19]

Grimes A (2007), ‘Impacts of Land Availability, Housing Supply and Planning
Infrastructure on New Zealand House Prices’, paper presented to Treasury
& Reserve Bank of New Zealand conference ‘The Business Cycle, Housing
and the Role of Policy’, Wellington, 10–11 December.

National Housing Strategy (1992),
National Housing Strategy: Agenda for Action, Australian Government
Publishing Service, Canberra.